International Trade Theory

Evolution of Trade Theory

-Mercantilism -Absolute Advantage -Comparative Advantage ----Ricardo ----Heckscher-Ohlin (and Leontief Paradox) -International Product Life Cycle -New Trade Theories -National Competitive Advantage -Neo-mercantilism

The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. What are 7 unrealistic assumptions made with this:

1) Assumed a simple world with only two countries and two goods. There are many countries and many goods. 2) Assumed away transportation costs btw countries. 3) Assume away differences in the prices of resources in different countries. What about exchange rates? 4) Assume that resources can move freely from the production of one good to another within a country. 5) Assume a constant return to scale. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good. 6) Assume that each country has a fixed stock of resources. Does not make allowances for the dynamic changes in a country's stock of resources. 7) Assumed away the effects trade on income distribution within a country.

Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage. What are these attributes?

1) Factor endowments. Skilled labor/infrastructure. 2) Demand conditions. Home demand for product or service. 3) Related and supporting industries. The presence or absence of supplier/related industries. 4) Firm strategy, structure, and rivalry.

Porter's ideas on firm strategy, structure and rivalry:

1) different nations are characterized by different management ideologies. 2) vigorous domestic rivalry induces firms to look for ways to improve efficiency.

Opening an economy to trade is likely to generate dynamic gains of two sorts:

1) free trade might increase a country's stock of resources as increased supplies of labor and capital from abroad become available for use within the country. 2) Free trade might also increase the efficiency with which a country uses its resources. Opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency.

The New Trade Theory make what two important points?

1) through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of goods. 2) the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

Define the term, trade theory of Absolute Advantage (Adam Smith):

A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. According to Smith, countries should specialize in the production of goods for which they have the absolute advantage and then trade these goods for goods produced by other countries. A country should never produce foods at home that is can buy at a lower cost from other countries. The specializing in the production in goods.

Define the term, Factor Endowments:

A country's endowment with resources such as land, labor and capital. The more abundant a factor, the lower it cost.

Define the term, Zero-Sum Game

A situation in which an economic gain by one country results in an economic loss by another.

Chapter Summary:

Absolute advantage suggests that countries differ in their ability to produce goods efficiently. Countries should specialize in producing goods in areas where it has an absolute advantage.

Define the term, First-mover advantage:

Advantages accruing to the first to enter a market. By pioneering this market category, Airbus may have captured a first-mover advantage based on scale of economies that will be difficult for rivals to match.

What is the weakness of the Product Life-Cycle Theory?

Although Vernon's theory may be useful for explaining the pattern of international trade during the period of US global dominance, its relevance in the modern world seems more limited.

Mercantilism:

An economic philosophy advocating that countries should simultaneously encourage exports and discourage imports. The mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. They recommended policies to maximize exports and minimize imports. Imports were limited by tariffs and quotas, while exports were subsidized.

What two additional variables can influence the national diamond in important ways?

Chance (major innovations) and government (choice of policies)

Benefits of trade

Common sense suggests that some international trade is beneficial. Theories of Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce itself. It allows a country to specialize- produce more efficiently. One key insight of IT theory is that limits on import are often in the interests of domestic produces but not domestic consumers.

Chapter Summary:

Comparative advantage also suggests that opening a country to free trade stimulates economic growth.

Chapter Summary:

Comparative advantage suggests that is makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries.

Chapter Summary:

Comparative advantage suggests that unrestricted free trade brings about increased world production- positive-sum game.

Define the term, Economies of Scale:

Cost advantages associated with large-scale production. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment.

Many economic studies have looked at the relationship btw trade and economic growth.

Countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. Over the period of 1950-1998, countries that liberalized their trade regimes experienced, on average, increases in their annual growth rates of 1.5 percent compared to pre-liberalization times. Clear message: Adopt an open economy and embrace free trade, and your nation will be rewarded with high economic growth rates. Despite the shot term adjustment costs associated with adopting a free trade regime, trade would seem to produce greater economic growth and higher living standards in the long run.

Porter's ideas on demand conditions:

Firms are typically most sensitive to the needs of their closest clients. The characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Firms gain competitive advantage if their domestic consumers are sophisticated and demanding. Ex. Japan. Cameras. Knowledge consumers= innovative models

Chapter Summary:

Firms involved in IT can and do exert a strong influence on government policy toward trade. By lobbying government, business firms can promote free trade or trade restrictions.

Porter's ideas on factor endowments:

Hierarchies among factors. Basic factors (natural resources, climate, location and demographics) and advanced factors (communication infrastructure, sophisticated and skilled labor, research facilities, technological know-how)- He argues that advanced factors are the most significant for competitive advantage. Advanced factors are a product of investment by individuals, companies, and governments. Government investment in basic and higher education, by improving the general skill and knowledge of the population.

Explain the inconsistency David Hume found in the mercantilist doctrine with England and France as the example:

If England had a balance-of-trade surpls with France (it exported more than it imported) the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. France's money supply would contract and its prices would fall. This would encourage French to buy less English products and the English to buy more French goods (because they are so much cheaper now). Equals a deterioration of English balance of trade.

It then compares Ghana to South Korea....

If each country were to specialize in producing the goods for which it had an absolute advantage and then trade with the other for the good it lacks.....thus, by specializing, the production of both goods could be increased. As a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.

Talk a little about Ricardo's theory of Comparative Advantage in terms of the Ghana and South Korea example:

In light of Ghana's absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both rice and cocoa, it only has a comparative advantage in the production of cocoa. Ghana can produce 4 times as much cocoa as SK, but only 1.5 times more rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.

What is the Heckscher-Ohlin Theory?

It put forward a different explanation of comparative advantage. They argues that comparative advantage arises from differences in national factor endowments.

What are the implications of the New Trade Theory?

It suggests that nations may benefit from trade even when they do not differ in resources endowments or technology. Trade allows a nation to specialize in the production of certain products. The variety of products available to consumers in each nation is increased, while the average cost of those products should fall. New Trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advantages.

What is the Leontief Paradox?

Its a dilemma for economists. They prefer the Heckscher-Ohlin Theory on theoretical grounds, but it is relatively poor predictor of real-world international trade patterns. On the other hand, the theory they regard as being too limited, Ricardo's theory of comparative advantage (too many assumptions), actually predicts trade patterns with greater accuracy.

Chapter Summary:

Mercantilists argued that it was in a country's best interests to run a balance-of-trade surplus. Trade was viewed as a zero-sum game- one country's gains cause losses for other countries.

Chapter Summary:

New trade theory states that trade allows a nation to specialize in the production of certain goods, attaining scale economies and lowering the costs of producing those goods.

Chapter Summary:

New trade theory: Countries may predominate in the export of certain products simply because they had a firm that was a first mover in that industry.

Can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, non constant returns to specialization, and dynamic changes?

Once all assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the "new trade theory" to lose some of its strength. Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.

Porter's diamond:

Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry. The presence of all four components is usually required for this diamond to boost competitive performance. Government can also influence the diamond.

Chapter Summary:

Porter's theory.

Figure 6.1 shows Ghana in the theory of Absolute Advantage (Cocoa and rice). The different combinations that Ghana could produce are represented by the line GG. This refers to PPF. What is this?

Production possibility frontier

Talk about the ideas towards Immobile Resources

Resources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. Embracing free trade regime for an advanced economy such as the US often implies that the country with produce less of some labor intensive goods such as textiles and more of some knowledge intensive good such as computer software. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job. Resources do not always move easily from one economic activity to another. Process creates friction and human suffering. Political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. Governments often ease the transition toward free trade by helping to retrain those who lost their jobs. The pain caused by the movement towards free trade regime is a short term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.

The Heckscher-Ohlin Theory predicts what?

That countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that intensive use of factors that are locally scarce. It attempts to explain the pattern of international trade that we observe in the world economy. Argues that the pattern of IT is determined by differences in factor of endowments, rather than differences in productivity.

What is the basic message of the theory of Comparative Advantage:

That potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo's theory suggests that consumers in all nations can consume more if there are no restrictions on trade. The theory of Comparative Advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains.

Chapter Summary:

The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. Countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

Free Trade

The absence of barriers to the free flow of goods and services btw countries.

New Trade Theory:

The observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages. Certain industries in the world market can support only a limited number of firms. Firms that enter the market first build a competitive advantage. Ex. Boeing

Porter's ideas on related and supporting industries:

The presence of suppliers or related industries that are internationally competitive. The benefits of investment in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally.

Chapter Summary:

The product life cycle theory suggests that trade patterns are influenced by where a new product is introduced.

Define the term, Constant Returns to Specialization:

The units of resources required to produce a good are assumed to remain constant no matter where one is on a country's production possibility frame. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. In reality, most countries do not specialize, but instead produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns.

Chapter Summary:

Theories of IT are important to an individual business firm primarily because they can help the firm decide where to locate its various production activities.

Chapter Summary:

This chapter looks at why it is beneficial for a country to engage in international trade and explained the pattern of international trade observed in the world economy.

What does, National Competitive Advantage: Porter's Diamond, attempt to answer?

To explain why a nation achieves international success in a particular industry.

What did David Ricardo do with Adam Smith's trade theory of Absolute Advantage?

Took it one step further by exploring what might happen when one country has an absolute advantage in the production of all goods. He created the trade theory of Comparative Advantage.

1) Increased product variety and reducing costs...

Trade is thus mutually beneficial because it allows for the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices.

What is the Product Life-Cycle Theory? (Raymond Vernon)

Vernon argued that the wealth and size of the US market gave US firms a strong incentive to develope new consumer products. The high cost of US labor gave US firms an incentive to develop cost-saving innovations. Vernon argued that most new products were initially produced in America. Early in the life cycle of a typical product, while demand is starting to grow rapidly in the US, demand in other advanced countries is limied to high-income groups. Over time the demand for the new product starts to grow- it become worthwhile for foreign producers to begin producing for their home markets. Consequently, production within other advanced countries begins to limit the potential for exports from the US. Price become the main competitive weapon. If cost pressures become intense, the US has lost its advantage to other advanced countries- this might be repeated again when developing countries begin to acquire a production advantage over advanced countries.

In the "Extensions of the Ricardian Model" we relax what three assumptions?

We relax the assumption that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country's stock of resources or the efficiency with which those resources are utilized.

According to Porter, what do firms need to most likely succeed in industries or industry segments?

When the diamond (the four attributes) are more favorable.